Chapter 11

Managing Economies of Scale in a Supply Chain: Cycle Inventory Cycle inventory exists because
producing or purchasing in large lots allows a stage of the supply chain to exploit economies of scale
and thus lower cost. A lot or batch size is the quantity that a stage of a supply chain either produces
or purchases at a Time Cycle inventory is the average inventory in a supply chain due to either
production or purchases in lot sizes that are larger than those demanded by the customer.

Cycle inventory is held to take advantage of economies of scale and reduce cost within a supply
chain. For example, apparel is shipped from Asia to North America in full container loads to reduce
the transportation cost per unit. Key cost in the lot-sizing decision is the average price paid per unit
purchased. The fixed ordering cost includes all costs that do not vary with the size of the order but
are incurred each time an order is placed. Holding cost is the cost of carrying one unit in inventory
for a specified period of time, usually one year

The following costs must be considered in any lot-sizing decision:

• Average price per unit purchased, $C/unit

• Fixed ordering cost incurred per lot, $S/lot

• Holding cost incurred per unit per year, $H/unit/year = hC Cycle inventory exists in a supply chain
because different stages exploit economies of scale to lower total cost which include material cost,
fixed ordering cost, and holding cost.

Any stage of the supply chain exploits economies of scale in its replenishment decisions in the
following situations:

1. A fixed cost is incurred each time an order is placed or produced.

2. The supplier offers price discounts based on the quantity purchased per lot.

3. The supplier offers short-term price discounts or holds trade promotions.

Inventory Holding Cost: Holding cost is estimated as a percentage of the cost of a product and is the
sum of: Cost of capital, Obsolescence (or spoilage) cost, Handling cost, Occupancy cost and
Miscellaneous costs.

Obsolescence (or spoilage) cost: The obsolescence cost estimates the rate at which the value of the
stored product drops because its market value or quality falls. This cost can range dramatically, from
rates of many-thousand percent to virtually zero

Handling cost: The quantity-dependent handling cost does not change if quantity varies within the
range. If the quantity handled requires more people, an incremental handling cost is added to the
holding cost.

Occupancy cost: The occupancy cost reflects the incremental change in space cost due to changing
cycle inventory

Miscellaneous costs: These costs include theft, security, damage, tax, and additional insurance
charges that are incurred. Once again, it is important to estimate the incremental change in these
costs on changing cycle inventory.
Ordering Cost: The ordering cost includes all incremental costs associated with placing or receiving
an extra order that are incurred regardless of the size of the order. Components of ordering cost
include:

Buyer time: Buyer time is the incremental time of the buyer placing the extra order Transportation
costs: Transportation costs includes a fixed component that is independent of the quantity shipped
and a variable component that increases with the quantity shipped.

Receiving costs: These include any administration work such as purchase order matching and any
effort associated with updating inventory records Effect of Lot Size on Costs at Best Buy The
economic order quantity (EOQ) is the optimal lot size to order. Total ordering and holding costs are
relatively stable around the economic order quantity. A firm is often better served by ordering a
convenient lot size close to the EOQ rather than the precise EOQ. Aggregating orders and deliveries
across product families is an effective mechanism to lower cycle inventories.

Aggregating replenishment across products, retailers, or suppliers in a single order allows for a
reduction in lot size for individual products because fixed ordering and transportation costs are now
spread across multiple products, retailers, or suppliers Lot Sizing with Multiple Products or
Customers:

Three approaches to the lot-sizing decision: Order the model independently, jointly order every
product in each lot, order jointly but not every order contains every product. Lots are Ordered and
Delivered Independently for Each Product In this approach, each product is ordered independently
of the others. This method ignores the opportunity to aggregate orders. Best method for lowering
the lower costs is by combining orders on a single truck. Simple aggregation is effective when
product-specific order costs are small, and tailored aggregation is best if product-specific order costs
are large.